Perspectives sur les enjeux contemporains | More Perspective on Current International Issues

The 2008 financial crisis was all about a mispricing of risks. For years investors reaped the rewards of investing in risky securities such as mortgage-backed ones, and now they are simply bearing the costs. But the fact is, very few investors knew these assets were risky. Thanks to triple-A ratings by the credit rating agencies, investors were blindly guided into a dry well. What should the Obama administration do with the rating agencies? They should “write” them out of the law, or nationalize them. It is all about setting the incentives of bankers and credit rating agencies correctly.

Eflon, Foreshadowing, 2009
Certains droits réservés.

Since being sworn in as the 44th President of the United States, Barack Obama’s main focus has been to finish preparing a massive fiscal ‘stimulus’ package in hopes that it will help the U.S. out of one of the worst recession in decades, one that is looking dangerously like the Japanese experience of the 1990s – a bubble burst followed by a decade-long of depression economics. As a result, some important issues are left aside at the moment, so that efforts are concentrated on restoring confidence in financial markets. But the Obama administration will have much more on its agenda for the next four years: if they are able to stop this self-reinforcing downward spiral, the new administration will have to deal with several important issues, especially health care reforms, wars in Afghanistan and Iraq, and new financial regulations. The first two issues have been in the air for a certain time, but the latter wasn’t a problem until the current financial crisis – in fact, the deregulation of financial markets during the 1990s was seen by many as a powerful engine capable of absorbing shocks while delivering long-term economic growth. Now, with what has happened with the U.S. financial system, people are advocating that strict policies should come in place to regulate financial markets so that a crisis like the current one won’t happen again. Institutions that act like banks need to be regulated like banks, and risks must be priced appropriately by unbiased, highly knowledgeable, and well-informed credit rating agencies. These credit rating firms, like Moody’s, Standard and Poor’s, and Fitch, were hardly criticized by the U.S. Congress last October for their role in the financial mess, i.e. by failing to give the appropriate credit ratings to risky assets like securities backed by subprime mortgages.

Why did the credit rating agencies fail to assess risk properly?

There are a few relatively simple explanations for that. First, these agencies are paid by the security issuers; so it is understandable that once in a while, the interests of these agencies might come before the ones of the investors. On the other hand, Mr. Robert Rosenkranz, chairman and CEO of Delphi Financial Group, states in a very interesting piece in the Wall Street Journal that it is not surprising at all that these agencies wrongly assessed the risks of trillions of bonds backed by mortgages (1). « Rating agencies employ quite ordinary mortals to analyze the credit risk of bonds, just as firms like Goldman Sachs and Merrill Lynch employ quite ordinary mortals to analyze the outlook for stocks. No one is shocked when equity analysts’ recommendations don’t pan out. Why should we expect any more of the rating agencies? » Quite true. And as Mr. Rosenkranz further says, these ratings determine (by law) how much capital regulated institutions need in order to own the bonds. So from here we can finish up the math: safe securities mean high ratings, and high ratings mean low capital requirements. So when risky assets (let’s say a bundle of subprime mortgages) are assigned high ratings, this implies strong demand for them (investors think there are safe). Regulated financial institutions invested massively in these assets, with very low capital required in order to own these fixed-income securities. Now when subprime borrowers start defaulting on their mortgage payments, the banks don’t have enough capital to back up their obligations.

What Mr. Rosenkranz is proposing is to change how the credit ratings are set. Basically, he states that the market should determine them, not the rating agencies: « The amount of capital required to hold a fixed-income security should be determined not by a rating but by its yield, expressed as a spread over Treasuries. The higher the spread, the riskier the market has determined the asset to be, and more capital should be required to hold it. » He finally argues that the credit rating agencies should still be out there, but only producing « Consumer Reports », i.e. to give advice on which assets are safe or not. It is strictly better than what we have now, since it assesses the rating agencies’ incentives correctly: institutions or investors will buy their reports only if they are actually good at pricing the risks, meaning that these rating agencies will feel the benefits, but also the costs of their actions.

Is this enough to prevent another financial crisis?

Even if it is better than our current rating system, it is not sure whether it is enough to prevent the financial markets from going through other crises. It is widely known that financial markets have had speculative bubbles, especially in the stock markets. As stated above by Mr. Rosenkranz, there are firms like Goldman Sachs or Merrill Lynch that employ financial analysts whose jobs are to appropriately value companies that are listed on different stock exchanges; simply put, they produce « Consumer Reports » to investors. But this did not stop the technology-stocks bubble of the 1990s; in fact, it may even have exacerbated it because of analysts’ overvaluation of stocks. Herd behavior and feedback loops are common in the financial markets, so letting the markets decide the yields of fixed-income securities will not prevent irrational exuberance.

Another important issue about the proposition of Mr. Rosenkranz is the influence of big investors who can manipulate the market for a short period of time. Let’s say that the market sets the yields on fixed-income securities, as described in the proposition above. Moreover, let’s assume that a small bank has invested in some risky assets, and for some reason sees its capital reserves decrease suddenly; in that case, what will prevent institutions like hedge funds to « force » a run on the bank by manipulating the bond market and shorting the bank’s stock? Paul Krugman, laureate of the Economics Nobel prize in 2008, described in his book « The Return of Depression Economics » how hedge funds exacerbated the crises in some Asian economies between 1997 and 1998 by running down the countries’ foreign currencies reserves to benefit from currency devaluations (2). This kind of manipulation of the markets could also happen in the bond market, and in turn this could trigger an unwinding of assets like we have seen in the current crisis.

Why not nationalize credit rating agencies?

The credit agencies should be nationalized; if not possible, this task should be given to the Federal Reserve or the SEC. Under this system, each investor would pay a very small fee each time he does a transaction in a regulated financial market, thus creating a pool of funds used to run these credit agencies. The government could design a performance-based pay scheme, which would reward the best analysts in these credit rating agencies. This way the agencies’ analysts would have their incentives set correctly. This setup would be costly and not very efficient, but it might be the price to pay to prevent another 2008-type financial crisis.